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ETFs Offer a False Haven From a Nonexistent Storm

(Bloomberg Opinion) -- The market for exchange-traded funds has more than doubled in the past five years, reaching about $5 trillion. This explosion has largely been driven by investors seeking a cheap and simple way to track the returns of benchmark indexes. But buyers are starting to shift to more complex flavors of ETF as a defensive reaction to the stock market declines seen in the final quarter of last year. They may find their timing is off.

A survey of ETF owners published this week by Brown Brothers Harriman & Co. suggests the market will continue to grow, with 61 percent of respondents saying they plan to increase the amount of money allocated to the asset class in the coming year. What’s more interesting is the change in the priorities fund managers say are driving their purchases.

In the survey, investors in the U.S. and Europe ranked historical performance alongside cost as the most important criteria. That’s a contrast with last year’s survey, when the expense ratio came first in both regions. Past performance only ranked third for U.S. buyers and didn’t make the top four for their European counterparts.

So while the cheapness of ETFs is still an attraction, it’s no longer their overriding selling point. “Investors are willing to pay a premium for products that can either mitigate risk or generate out-sized returns — particularly during periods of heightened volatility,” BBH says.

That shift to emphasizing returns coincides with an evolution in the motivation for buying smart beta products, which eschew the more typical market capitalization-weighted products in favor of rule-based selections driven by factors such as value, momentum or volatility.

In previous surveys, BBH says most buyers of smart beta and active ETFs were typically seeking to generate additional alpha. Now, about 70 percent of purchases of those more sophisticated products are designed to protect portfolios from increased risk or an acceleration in volatility, the survey showed.

The cautious stance looks like a reaction to what happened in the final quarter of last year, when the MSCI World Index dropped by more than 13 percent, as did the S&P 500 index. That’s underlined by the growing interest in fixed income, ranked in the survey as the asset class most investors would like to see more ETFs made available in.

But old-fashioned beta continues to deliver: Global stock markets have bounced back this year as the Federal Reserve and other central banks, faced with slowing growth, seem willing to hold off the monetary-policy brakes. Fund managers may find that their efforts to protect returns from a renewed market downturn come with added costs and complexity that turn out to be unnecessary.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Mark Gilbert is a Bloomberg Opinion columnist covering asset management. He previously was the London bureau chief for Bloomberg News. He is also the author of "Complicit: How Greed and Collusion Made the Credit Crisis Unstoppable."